Tuesday, December 22, 2009

Is the Bond Market Signaling A Stronger Recovery?

From the WSJ:

A closely watched bond-market measure of investor optimism hit a record Monday, amid signs the U.S. economy's recovery is strengthening.

That measure is the yield curve -- the difference between short-term and long-term interest rates on government bonds. That number is at its highest level ever, surpassing the record set in June, and signals that investors are expecting a stronger economic turnaround ahead.

The milestone comes amid a broad sell-off in government bonds, as investors shift money into riskier assets like stocks in anticipation of stronger growth. Last year, investors dumped stocks and sought the safety of government bonds amid the financial panic. That drove up the prices of government debt, and thus drove down the yields on some to record lows.


The yield curve steepens when the Federal Reserve, which controls short-term interest rates, keeps them low to spur the economy. But at the same time investors, expecting growth to resume and with it the possibility of inflation, sell longer-term government bonds, which sends their prices down and their yields up.

This argument assumes that long-term investors are selling their bonds to move into riskier assets. That may be part of the reason. But another reason may be

1.) Overall concern about the U.S.' long-term finances. The U.S. is running massive deficits and will be for at least one more year. There may be concern about whether or not the government can keep up with this development.

2.) Inflation. First, this isn't an issue right now. The recent spike in PPI and CPI is entirely based on oil prices which have come over the last few weeks. However, gold recently went to a very high level (although it is currently in a sell-off). Inflationary fears are a primary reason for this increase. So the fear of inflation is definitely in the air.